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Original Equipment Manufacturing Contract and Three-Way Bargaining: Cooperation, Control, and the Opportunism Within

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Abstract

This chapter discusses the original equipment manufacturer (OEM), a model of large-scale industrial production that is popular today in many sectors of industry, especially in the information technology industry. An OEM’s contractual setting usually involves a three-party negotiation, which includes a product design company/brand owner, an OEM, and a component supplier. The underlying logic of the OEM model is the delegation of manufacturing tasks to different players with different skill sets or specialties for a better allocation of resources. However, this contractual design also entails much complexity in its coordination, as modern manufacturing often has dozens or hundreds of units or steps before a final product is complete.

The author further discusses the phenomenon of the “technical service charge” contract, which is a side agreement between an OEM and a component supplier that allows the OEM to receive a payment or rebate from the component supplier even though there is no real exchange of goods or services involved. The technical service charge contract exemplifies the commercial opportunism and dynamics of adjustment at work in the multi-party supply chains of modern-day manufacturing. Examining this contractual design sheds light on how contracting parties extract benefit from the arrangement.

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Notes

  1. 1.

    OEM is a term that is used in several ways that are slightly different from each other and sometimes even conflicting. For example, in Wikipedia, OEM is a company that “makes a part or subsystem that is used in another company’s end product.” See https://en.wikipedia.org/wiki/Original_equipment_manufacturer. Accessed 23 June 2017. In Merriam-Webster’s dictionary, OEM means a company “that produces complex equipment (as a computer system) from components usually bought from other manufacturers.” See https://www.merriam-webster.com/dictionary/OEM. Accessed 23 June 2017. According to Investopedia, in its traditional meaning, OEM means “a company whose goods are used as components in the products of another company, which then sells the finished item to users.” However, in a newer definition from Investopedia, OEM refers to “the company that buys products and then incorporates or rebrands them into a new product under its own name.” See Original Equipment Manufacturer—OEM Definition, Investopedia at http://www.investopedia.com/terms/o/oem.asp. Accessed 23 June 2017. The company in the second definition of OEM in Investopedia is termed brand owner in this article, to avoid confusion.

  2. 2.

    Xu (2012), pp. 13–14.

  3. 3.

    Apple has been the largest company in the world by market capitalization since late 2011, taking this position from ExxonMobil. See https://en.wikipedia.org/wiki/List_of_public_corporations_by_market_capitalization. Accessed 23 June 2017.

  4. 4.

    Company Profile: Apple Inc. Available at http://www.reuters.com/finance/stocks/companyProfile?rpc=66&symbol=AAPL.O. Accessed 23 June 2017.

  5. 5.

    Value chain is a concept that includes a set of interrelated activities a company uses to create a competitive advantage. The idea was pioneered by Michael Porter in his influential book Competitive Advantage in 1985.

  6. 6.

    Duhigg and Barboza (2012).

  7. 7.

    A useful and widely circulated overview of Apple iPhone 6’s supply chain is “How & Where iPhone Is Made: Comparison of Apple’s Manufacturing Process,” available at http://comparecamp.com/how-where-iphone-is-made-comparison-of-apples-manufacturing-process/. Accessed 23 June 2017.

  8. 8.

    Wingfield and Duhigg (2012).

  9. 9.

    Apple Inc., Supplier List, February 2017, at http://images.apple.com/supplier-responsibility/pdf/Apple-Supplier-List.pdf. Accessed 23 June 2017. Obviously these lists that Apple publishes do not include many of the secondary suppliers, i.e., suppliers without a direct contract with Apple.

  10. 10.

    To fill out one’s view of Apple’s supply chain, a breakdown of the bill of materials shows the estimated price of all main components of the iPhone and their relationship to the whole. See http://www.supplychain247.com/article/apples_supply_chain_cost_of_making_the_iphone_7 (citing leading research institute IHS Markit’s report and estimate of a base model iPhone 7’s bill of materials at $219.80 U.S. dollars). Accessed 23 June 2017.

  11. 11.

    The Economist (2010). Much attention was drawn to Apple’s powerful OEM Foxconn Electronics by an article published by The New York Times in 2012. This article was written response to a series of worker suicides in Apple’s OEM Foxconn in China in 2010 and raised questions about safety and labor conditions there. By looking into the reasons for the serial suicides, this article provides a peek into Apple’s complex outsourcing structure. See Duhigg and Barboza (2012).

  12. 12.

    Apple Inc., Supplier Responsibility, at http://www.apple.com/supplier-responsibility/. Accessed 23 June 2017.

  13. 13.

    For some overview of Apple’s procurement policy and its endeavor to develop an ecosystem of suppliers, see Apple Inc., Apple and Procurement, at http://www.apple.com/procurement/. Accessed 23 June 2017. Surprisingly, if one looks back to 2011, 6 years prior to the time of this writing, Nokia was still the leading smart phone vendor in the world. (It ranked number one through the first quarter of 2011, shipping 23.8% of all smart phones to customers that season, while Apple owned 18.3% of the smart phone market.) However, Nokia disappeared completely from the market in the third quarter of 2012, merely 18 months later. Nokia’s precipitous fall exemplifies the stiff competition and volatility of the consumer electronics industry. Statista (2017).

  14. 14.

    See http://www.supplychainopz.com/2013/01/is-apple-supply-chain-really-no-1-case.html and https://supplychainminded.com/apple-supply-chain-strong-iphone-6-closes/. Accessed 23 June 2017. Similarly, IT research firm Gartner ranked Apple’s supply chain as the best supply chain in the world from 2009 to 2014. In 2015 and 2016, Apple was listed in the “Master” category for its “sustained supply chain leadership over the last 10 years.” See http://www.gartner.com/newsroom/id/3323617, http://www.gartner.com/technology/supply-chain/top25.jsp and http://www.supplychainopz.com/2013/01/is-apple-supply-chain-really-no-1-case.html. Accessed 23 June 2017.

  15. 15.

    Barboza (2016b). Investigative reporter Barboza provides an interesting inside look into Honhai/Foxconn’s deep-rooted management skill in China and its efficiency.

  16. 16.

    Barboza (2016a).

  17. 17.

    Australian Institute of Company Directors (2015). The tactics that Apple uses to control its suppliers include a long-term exclusive contract and prepayment to negotiate better price terms.

  18. 18.

    See http://comparecamp.com/how-where-iphone-is-made-comparison-of-apples-manufacturing-process/. Accessed 23 June 2017.

  19. 19.

    Coase (1937).

  20. 20.

    Ibid.; Hart (1989).

  21. 21.

    Hart (1989), p. 1760.

  22. 22.

    Coase (1937). p. 395.

  23. 23.

    Ibid., pp. 396–397.

  24. 24.

    Alchian and Demsetz (1972), pp. 777, 783.

  25. 25.

    Ibid.

  26. 26.

    See, generally, Williamson (1975, 1985).

  27. 27.

    Hart (1989), p. 1763.

  28. 28.

    See Wikipedia, Lean Manufacturing, https://en.wikipedia.org/wiki/Lean_manufacturing. Accessed 23 June 2017.

  29. 29.

    However, even when contracts are used as the means of obtaining needed parts, the purchase often tends to be, in the IT industry, a mid- or long-term, but not a one-time, relationship. Using contracts to manage a mid- or long-term relationship adds some twists to the original calculation and makes it more complex. In the view taken here, seeing this recurring possibility in fact changes the original contractual features and leads to arrangements closer to organization-like territory. I take up this point at more length later in the article.

  30. 30.

    Hart (1989), p. 1766.

  31. 31.

    Ibid., p. 1770.

  32. 32.

    Ibid.

  33. 33.

    Grossman and Hart (1986), Holmstrom and Tirole (1989) and Hart and Moore (1990).

  34. 34.

    The main sub-contractor can be a large AF and is in most cases. When all manufacturing work is outsourced to one main sub-contractor, that sub-contractor is customarily called, in the IT industry, an OEM.

  35. 35.

    See Wikipedia, List of Laptop Brands and Manufacturers, https://en.wikipedia.org/wiki/List_of_laptop_brands_and_manufacturers. Accessed 23 June 2017.

  36. 36.

    In the IT industry, securing a timely acquisition of key components may also be crucial to a BO, especially when new technology is embodied in those components. Because new components will affect the overall experience of a product, the goal is to acquire those key components as quickly as possible. For an OEM, similarly, getting familiar with new components’ performance and characteristics will give it advantages in quickly completing the manufacture of a product. This is critical in an industry where change is rapid and competition is fierce. In this situation, a “good relationship” between BO and OEM comes closer to being two-way reciprocity than one-sided reliance.

  37. 37.

    See Oliver (2012). Some of the literature on supply-chain management places much emphasis on monitoring suppliers. In fact, Apple is a frequent case cited as taking an intensive approach to such monitoring.

  38. 38.

    See Bibey (2014). In fact, to speak of true exclusiveness is an overstatement. In terms of OEM or AF, Apple does use two OEMs, Honhai and Pegatron, at least since 2014. Pegatron, interestingly, enjoys roughly half the order by estimation. The reason Foxconn is mentioned more often owes to a series of New York Times stories and, possibly, to the fact that Pegatron is responsible for smaller iPhones and Honhai, the bigger and more expensive ones.

  39. 39.

    See Dou (2016) and Lovejoy (2016).

  40. 40.

    See Webb (2016) and Leswing (2016).

  41. 41.

    See Randewich (2014) and Hein (2014).

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  1. National Chiao-Tung University, Hsinchu, Taiwan

    Chien-Chung Lin

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  1. Institute of Advanced Legal Studies, School of Advanced Studies, University of London, London, UK

    Maren Heidemann

  2. Law School, University of Exeter, Exeter, UK

    Joseph Lee

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Lin, CC. (2018). Original Equipment Manufacturing Contract and Three-Way Bargaining: Cooperation, Control, and the Opportunism Within. In: Heidemann, M., Lee, J. (eds) The Future of the Commercial Contract in Scholarship and Law Reform. Springer, Cham. https://doi.org/10.1007/978-3-319-95969-6_7

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